U.S. productivity revised up to 4.7%

Unit labor costs fall 1%, signaling low inflation

WASHINGTON (MarketWatch) - U.S. productivity accelerated in the third quarter while labor costs fell, the Labor Department said Tuesday, a sign that inflationary pressures may be milder than the Federal Reserve has thought.

Productivity of the U.S. nonfarm business sector surged at a 4.7% annual rate in the third quarter, the fastest rate in two years, and revised up from the 4.1% pace estimated a month ago. Read the full report.

Unit labor costs - a gauge of wage-push inflationary pressures - fell at a 1% annual pace in the quarter, revised lower from a 0.5% decrease. Unit labor costs are the costs paid to workers to produce one "unit" of output.

"This is great news on the inflation front," said David Greenlaw, economist for Morgan Stanley. "It will be very difficult for the economy to generate any sustained rise in core inflation with unit labor costs showing such a high degree of restraint."

Economists expected productivity to be revised to a 4.5% annual pace, based on revisions to output and hours worked already reported. See Economic Calendar.

The good news on inflation helped boost both stock and bond prices in early trades. See Market Snapshot.

Productivity increased at a 2.1% annual rate in the second quarter.

Because the data are so volatile on a quarterly basis, most economists take a longer view of a year or more when analyzing productivity.

Productivity has increased 3.1% in the past year, about double the 1.6% pace that prevailed from the mid-1970s through mid-1990s. It's the best year-on-year growth in productivity since early 2004.

Since 1999, productivity has averaged 3.3% annually, while unit labor costs have risen just 1%.

Unit labor costs have increased 1.8% in the past year, following a large downward revision in second-quarter unit labor costs from a 1.8% increase to a 1.2% decline.

The revisions to unit labor costs mean that compensation pressures, which were thought to be exploding earlier this year, actually have been rather tame.

Instead of growing at a 4.1% pace through the second quarter, as previously thought, unit labor costs are now growing at just 1.8%, less than half the rate of inflation.

Real hourly compensation (adjusted for inflation) is up 1.2% in the past year.

"This strong productivity performance explains why consumer price inflation shows no sign of heating up, despite the recent volatility in energy prices," said Peter Morici, a professor in the business school at the University of Maryland. "Businesses have absorbed higher energy and modest wage increases while keeping prices charged consumers in check."

Although the new figures will likely show much less inflationary pressures from labor costs, that doesn't mean the Federal Reserve will change course and end its tightening campaign. Read more about the Fed and unit labor costs.

The Fed is expected to raise its short-term interest rate target for a 13th straight time at the meeting next Tuesday.

"The Fed is already changing the rationale for tightening to 'inflation expectations,'" said Neal Soss, chief economist for CSFB before the release. "The 'unit labor cost' story just doesn't hold water."

Joseph LaVorgna, chief U.S. fixed income economist for Deutsche Bank, said unit labor costs "are a statistically insignificant predictor of inflation" anyway. "Core inflation could head higher even if unit labor costs do not."

Bear Stearns chief economist John Ryding said he didn't believe the data.

The good news from the third quarter is likely an anomaly because the hurricanes delayed hiring, said Matthew Martin, an economist for Moody's Economy.com. "In effect, the hurricanes will end up delaying the eventual cost pressures emanating from the labor market by about one quarter."

Productivity, defined as output per hour worked, is perhaps the most important long-term variable in economics.

Higher productivity can mean higher profits, wages and living standards and can keep inflationary pressures at bay. But the concept is difficult to measure, especially in financial services where the concept of a "unit" of output is murky.

In nonfinancial corporations, productivity increased at a 3.2% pace in the third quarter and is up 4.7% in the past year. Unit labor costs increased 1.3% in the third quarter and are up 0.7% in the past year.

Unit profits fell 2.9% in nonfinancial corporations in the third quarter, the first decline in nearly two years, a period that has seen unit profits rise 47%.

In the manufacturing sector, productivity increased at a 3.4% annual pace in the third quarter while unit labor costs fell 0.3%. Manufacturing productivity is up 4.5% in the past year while unit labor costs are up 1.7%.

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